Tuesday, November 11, 2008

"Money, Banking and the Federal Reserve"

I just finished viewing a youtube video produced by the Mises Institute that gives an interesting explanation of how money and banking works. Every freshman in Econ 101 needs to watch this video to learn why berries or wampum could be the currency of choice, rather than reserve notes, and what fractional reserve banking is all about. It also covers a good bit of banking history, although as I will discuss in a bit, it is highly selective in its coverage of the subject.

Then the video engages in a long rejection of central banking, and calls for a return to the gold standard. There are several related themes that the Mises Institute cites:

The Federal Reserve Board of Governors (FRB) is not accountable to anyone. No one audits their operations; they can buy and sell assets as they please. You cannot obtain a transcript of their deliberations; they only publish a brief summary.

Inflation is baked in to the current banking system--300% in the 25 years after Nixon ended Bretton Woods! But you don't want a low inflation environment; you want the currency you own to gain value over time. Only a deflationary environment can provide the confidence that investors and entrepreneurs need to do their part for economic growth.

Central banking is the cause of all economic booms and busts. It leads to booms and busts because the presence of a "lender of last resort" removes the need for banks to lend prudently during the good years.

History shows that a return to the gold standard will stabilize the economy; for example, sound money was the impetus for a pleasant 18-year expansion from 1879 to 1896. On the other hand, the video implicates central banking as the ultimate cause of the Great Depression.

The video's analysis ignores so much history, so much about how banking operates, and so many serious pragmatic issues, that I scarcely know where to begin my critique. For now, since my time is limited, I'll just list some semi-random thoughts:

The members of the Federal Reserve Board are appointed by the President and confirmed by the Senate. Opinions vary as to whether this provides enough accountability for the Board, but the appointment/confirmation process certainly mitigates the problem. In addition, the video is dramatically wrong about the availability of transcripts for the FRB's meetings; they have been available since 1994. The video was produced in 1996, so there is no excuse for this misleading argument.

Central banking's promotion of monetary inflation is not the only cause of the boom/bust cycle. Any time investors believe that outsized profits can be gained from some new resource, technology or business practice, they stampede into the capital market and produce a rush of new lending. This is a boom cycle, and it doesn't need the assistance of central banking. The Holland tulip craze, the 19th century railroad boom, and the 21st century housing boom were driven primarily by investors' appetites for enormous and easy returns. The video praises the reliability of a market-regulated currency, but in point of fact the rush into the housing market by Wall Street lenders and Main Street borrowers that we saw during W's early years is but the latest example of how the market can drive a currency boom. An earlier example, provided by the video itself, is how the long expansion after the Civil War was followed by a decade's worth of instability that culminated in the Crash of 1907. That crash in turn led to the birth to the Federal Reserve during a 1910 meeting of Wall Street titans on Jekyll Island. Of course, the fact that 18 years of boom followed by a decade of instability and bust occurred when the Fed did not yet exist is an extremely strong refutation of the video's argument, but the producers rise to the challenge of completely overlooking this inconvenient fact.

While few are happy during the bust after a boom, Daniel Gross argues that the boom/bust cycle is critical for a healthy economy. Booms often give us infrastructure (like telegraphs, railroads, and fiber-optic cable) that can boost production for decades. Of course, not all booms are of equal value (think tulip bulbs and vacant housing), but you've got to expect some chaff with the wheat. At the risk of redundancy, I again point out that booms are what happen when investors get excited about emerging opportunities; history has proven that you can't have marvelous new opportunities without a boom/bust cycle.

Do not believe the video when it states that you want your money to gain value over time. The years 1929 - 1940 saw the greatest increase in the value of money in American history; this period is also referred to as the Great Depression. The link between increasing money value and severe economic depression is quite obvious. If the value of goods I can buy with money will increase over time, I have no incentive at all to invest it; I can get a risk-free increase in value just by stuffing my money in a mattress. So from the viewpoint of society, when the value of money is increasing, investment naturally falls sharply. Furthermore, this fall in value can be a vicious circle: as the value of money increases, investment drops; as investment drops, economic activity drops; as economic activity drops, the value of money in hand goes up; as the value of money in hand goes up, investment drops more, etc. This, in a nutshell, is how the Great Depression happened.

The video attacks fractional reserve banking from pillar to post, but it is impossible for a conversion to the gold standard to eliminate fractional reserve banking. Here's why: the world's outstanding gold reserves are but a tiny fraction of the world's economic output. As long as the reserve assets on hand are but a fraction of the lending in the economy, there will be fractional reserve banking. It is mathematically impossible to have any form of banking other than fractional reserve banking when aggregate reserves are lower than aggregate deposits. "Well, we'll just revalue gold so that banking reserves and demand deposits are in equilibrium," Ron Paul might reply. While that is possible, I'm not sure I want to give a windfall profit of $15 trillion to a handful of mining companies.

The video proclaimed (in 1996) that the federal budget had been in deficit every year since Nixon ended Bretton Woods. Of course, just like it seems you have to wash your car to enjoy a rainfall, no sooner was this video released than our country enjoyed a string of impressive budget surpluses from 1996 to 2001. Of course, the Republican Congress and President put an end to that with a huge tax cut and out-of-control military spending in the years 2001 and following, but that's a different story.

The video proposes that investors will lend their gold to banks for (negotiated) fixed periods of time at a fixed interest rate, and the banks will in turn will lend to creditworthy borrowers. Congratulations, Mises Institute, you have just invented the Certificate of Deposit (CD).

The video proposes that banks will charge fees to depositors for holding their savings and demand deposits, instead of earning profits by lending a portion of the deposit money. In other words, the Mises Institute proposes to kill fractional reserve banking. Of course, this would decrease the availability of capital dramatically, which would starve our economy of the resources needed to pursue new investment opportunities. In other words, the Mises Institute's proposal would provoke a downturn so colossal that we would rename the 1930s as the "Mild Disappointment."

It is true that deposit insurance and the Fed's discount window serve as a "lender of last resort," which can encourage private lenders to take some imprudent risks. However, the alternative is not some nirvana where all investors and lenders are perfectly rational. Rather it's a system where you and I will be afraid to put our savings in a bank for fear that some crazy loan officer will lend it to his visionary cousin Marvin's real estate company, and we'll lose the capital we painfully gathered for decades as we raised our families. And if you and I are afraid of putting our money in savings accounts, it will be the 1930s all over again.

EDIT: I have corrected the inadvertant misspelling of the name of Mises Institute. Thanks, Thom!

6 comments:

Hi Chris, the problem with video in general is that you can't present a thorough explanation of anything with it, especially a subject as large as this. I don't necessarily agree with Mises, but if you'll read some of their writings at www.mises.org, you'll at least get a more thorough understanding of where they're coming from. By the way miso is a traditional Japanese food, and Mises is the name of the Institute. :)

Very quickly in answer to your objections:

1. It took them how many years to make the transcripts public? And perhaps there's an explanation for it not being in the video other than willful omission.

2. I don't believe they would say that central banking is the only cause of booms/busts. Fractional reserve banking also contributes. In fact that was the explanation in the video (it was mentioned almost off-handidly -- see my previous comment about the shortcomings of video). Also, the recent housing bubble was made much worse by the policies of the Fed. They make a very strong case for that on their website(s).

3.I think their argument is that central banking and fractional reserves magnify booms and busts.

4. You're generally right, at least in our current context, but I don't think you can draw any conclusions on their thoughts on deflation from the video. It's much too sketchy.

5. I've seen other alternatives which may or may not work, e.g. social credit, to fractional reserve banking, so I wouldn't say it is impossible. While I've not read much of the Mises Institute's proposals for the gold standard, I suspect that they have thought of your objection already.

6. Social Security and Medicare were not included in those "surpluses."

8 and 9. I don't know what they propose in place of fractional reserve banking, but the moral arguments against it are convincing for me (it is immoral for one to lend, at interest no less, something which he does not own, or indeed doesn't even exist). There does need to be a way to match the money supply with the real productive output of society. I do know that they propose the enabling of many different currencies, and not a monopolized government currency, so that may be part of their answer.

In general, I think the Mises fellows go too far in their trust in the Market, but on the other hand, our society is being wrecked by an almost religious faith in the power of Government. Those at the top, anyways, seem to believe that there is nothing that they cannot solve. If the degree of hubris indicates the severity of the fall, we're in for a really big one.

1. I believe it is possible for an argument to be misleading but not willful. I will concede that the Fed is imperfectly open and accountable, but the recent derivatives madness does not lead me to think that a more decentralized and less regulated banking system will somehow be less susceptible to booms and busts. Greenspan was a disciple of Ayn Rand, so he believed the markets would regulate themselves better than the Fed could. He recently admitted he was wrong.

I am not surprised at Paulson's refusal to be transparent, though. The W administration has consistently invoked secrecy and executive privilege beyond the point of absurdity. I think/hope Obama will improve the situation, though I'm sure we'll be disappointed from time to time in the next 4 to 8 years.

2. You can't have a bust without a preceding boom. Perhaps implementing the Mises Institute's suggestions will get decrease the amplitude of the boom/bust cycle, in the same way that amputating your arm will reduce the pain from a sore thumb. In other words, their suggestions will remove vast amounts of capital from the lending market, so yeah, it would be a very long time before there's a boom again (if ever).

3. But I'm not conceding the point that the net effect of the Fed is to exacerbate booms and busts. We managed to pull off the Great Panic of 1837 and the Crash of 1907 without the wind of a lender of last resort in our sails. Mises' historical analysis is quite misleading (in the non-willful sense). Mises also fails to discuss the 18 years of low inflation, relatively steady growth we experienced from 1983 to 2000 under the supposedly terrible current system. That long-forgotten period compares pretty well with Mises' favored period of 1879 - 1897. Yeah, at the end we had an ugly housing bubble when Greenspan and the Fed refused to regulate the private market for mortgage derivatives, but I don't follow the logic that would claim that we should therefore ditch centralized banking and rely completely on self-regulated capital markets. Isn't that the great experiment Wall Street just attempted with mortgage derivatives?

6. Future obligations will always be paid out of future economic production, so I have no problem with excluding Social Security and Medicare from the budgetary analysis. Of course, W's ghastly deficits are another story...

8 and 9. I have no moral problem with bank lending. In my opinion, a bank is simply acting as an agent/intermediary on behalf of the depositor(s). "If you deposit your money with us, we will put it to work for you by lending it to businesses and individuals at interest. We will give some of that return to you as interest on your savings or money market account. We will make a profit for ourselves on the differential between the higher lending rate and the lower deposit rate." Perhaps you can help me identify a moral problem with this view, but I don't see one at the moment.

I'm with you on the hubris issue. IMHO, the painful experience of the last 6 months is already the fruit of our staggering hubris. So yes, we ultimately set our hope on the city of God, not the city of man.

If you get the opportunity, you should read more of the Mises Institute (or Austrian economist) critique. This might be a good place to start. LewRockwell.com is another good place for it. You've obviously not read much if you think they ignore the '83 to 2000 bubble. It was a period of mostly artificial growth which we are now paying for.

Whether they have the right solutions, I don't know, but their diagnoses are...right on the money.

I don't have a problem with banks lending money that actually exists. It's money they create out of thin air that I find of dubious morality. And I find it especially dangerous for the central (no longer federal) government to have an unlimited supply of money at their behest by means of the central bank.

maybe not "mostly artificial" but at least there was a great deal of overly financed activity, both productive and unproductive which we're now paying for. Just trying to accurately state what I've read. Too big of a subject for my limited time...